The Principles of Political Economy, by John Stuart Mill

Chapter 11

Of Credit, as a Substitute for Money

§1. The functions of credit have been a subject of as much misunderstanding and as much confusion of ideas, as any
single topic in Political Economy. This is not owing to any peculiar difficulty in the theory of the subject, but to
the complex nature of some of the mercantile phenomena arising from the forms in which credit clothes itself; by which
attention is diverted from the properties of credit in general, to the peculiarities of its particular forms.

As a specimen of the confused notions entertained respecting the nature of credit, we may advert to the exaggerated
language so often used respecting its national importance. Credit has a great, but not, as many people seem to suppose,
a magical power; it cannot make something out of nothing. How often is an extension of credit talked of as equivalent
to a creation of capital, or as if credit actually were capital. It seems strange that there should be any need to
point out, that credit being only permission to use the capital of another person, the means of production cannot be
increased by it, but only transferred. If the borrower’s means of production and of employing labour are increased by
the credit given him, the lender’s are as much diminished. The same sum cannot be used as capital both by the owner and
also by the person to whom it is lent: it cannot supply its entire value in wages, tools, and materials, to two sets of
labourers at once. It is true that the capital which A has borrowed from B, and makes use of in his business, still
forms part of the wealth of B for other purposes: he can enter into arrangements in reliance on it, and can borrow,
when needful, an equivalent sum on the security of it; so that to a superficial eye it might seem as if both B and A
had the use of it at once. But the smallest consideration will show that when B has parted with his capital to A, the
use of it as capital rests with A alone, and that B has no other service from it than in so far as his ultimate claim
upon it serves him to obtain the use of another capital from a third person C. All capital (not his own) of which any
person has really the use, is, and must be, so much subtracted from the capital of some one else.1

§2. But though credit is but a transfer of capital from hand to hand, it is generally, and naturally, a transfer to
hands more competent to employ the capital efficiently in production. If there were no such thing as credit, or if,
from general insecurity and want of confidence, it were scantily practised, many persons who possess more or less of
capital, but who, from their occupations, or for want of the necessary skill and knowledge, cannot personally
superintend its employment, would derive no benefit from it: their funds would either lie idle, or would be, perhaps,
wasted and annihilated in unskilful attempts to make them yield a profit. All this capital is now lent at interest, and
made available for production. Capital thus circumstanced forms a large portion of the productive resources of any
commercial country; and is naturally attracted to those producers or traders who, being in the greatest business, have
the means of employing it to most advantage; because such are both the most desirous to obtain it, and able to give the
best security. Although, therefore, the productive funds of the country are not increased by credit, they are called
into a more complete state of productive activity. As the confidence on which credit is grounded extends itself, means
are developed by which even the smallest portions of capital, the sums which each person keeps by him to meet
contingencies, are made available for productive uses. The principal instruments for this purpose are banks of deposit.
Where these do not exist, a prudent person must keep a sufficient sum unemployed in his own possession, to meet every
demand which he has even a slight reason for thinking himself liable to. When the practice, however, has grown up of
keeping this reserve not in his own custody but with a banker, many small sums, previously lying idle, become
aggregated in the banker’s hands; and the banker, being taught by experience what proportion of the amount is likely to
be wanted in a given time, and knowing that if one depositor happens to require more than the average, another will
require less, is able to lend the remainder, that is, the far greater part, to producers and dealers: thereby adding
the amount, not indeed to the capital in existence, but to that in employment, and making a corresponding addition to
the aggregate production of the community.

While credit is thus indispensable for rendering the whole capital of the country productive, it is also a means by
which the industrial talent of the country is turned to better account for purposes of production. Many a person who
has either no capital of his own, or very little, but who has qualifications for business which are known and
appreciated by some possessors of capital, is enabled to obtain either advances in money, or more frequently goods on
credit, by which his industrial capacities are made instrumental to the increase of the public wealth; and this benefit
will be reaped far more largely, whenever, through better laws and better education, the community shall have made such
progress in integrity, that personal character can be accepted as a sufficient guarantee not only against dishonestly
appropriating, but against dishonestly risking, what belongs to another.

Such are, in the most general point of view, the uses of credit to the productive resources of the world. But these
considerations only apply to the credit given to the industrious classes-to producers and dealers. Credit given by
dealers to unproductive consumers is never an addition, but always a detriment, to the sources of public wealth. It
makes over in temporary use, not the capital of the unproductive classes to the productive, but that of the productive
to the unproductive. If A, a dealer, supplies goods to B, a landowner or annuitant, to be paid for at the end of five
years, as much of the capital of A as is equal to the value of these goods, remains for five years unproductive. Wring
such a period, if payment had been made at once, the sum might have been several times expended and replaced, and goods
to the amount might have been several times produced, consumed, and reproduced: consequently B’s withholding 100l. for
five years, even if he pays at last, has cost to the labouring classes of the community during that period an absolute
loss of probably several times that amount. A, individually, is compensated, by putting a higher price upon his goods,
which is ultimately paid by B: but there is no compensation made to the labouring classes, the chief sufferers by every
diversion of capital, whether permanently or temporarily, to unproductive uses. The country has had 100l. less of
capital during those five years, B having taken that amount from A’s capital, and spent it unproductively, in
anticipation of his own means, and having only after five years set apart a sum from his income and converted it into
capital for the purpose of indemnifying A.

§3. Thus far of the general functions of Credit in production. It is not a productive power in itself, though,
without it, the productive powers already existing could not be brought into complete employment. But a more intricate
portion of the theory of Credit is its influence on prices; the chief cause of most of the mercantile phenomena which
perplex observers. In a state of commerce in which much credit is habitually given, general prices at any moment depend
much more upon the state of credit than upon the quantity of money. For credit, though it is not productive power, is
purchasing power; and a person who, having credit, avails himself of it in the purchase of goods, creates just as much
demand for the goods, and tends quite as much to raise their price, as if he made an equal amount of purchases with
ready money.

The credit which we are now called upon to consider, as a distinct purchasing power, independent of money, is of
course not credit in its simplest form, that of money lent by one person to another, and paid directly into his hands;
for when the borrower expends this in purchases, he makes the purchases with money, not credit, and exerts no
purchasing power over and above that conferred by the money. The forms of credit which create purchasing power, are
those in which no money passes at the time, and very often none passes at all, the transaction being included with a
mass of other transactions in an account, and nothing paid but a balance. This takes place in a variety of ways, which
we shall proceed to examine, beginning, as is our custom, with the simplest.

First: Suppose A and B to be two dealers, who have transactions with each other both as buyers and as sellers. A
buys from B on credit. B does the like with respect to A. At the end of the year, the sum of A’s debts to B is set
against the sum of B’s debts to A, and it is ascertained to which side a balance is due. This balance, which may be
less than the amount of many of the transactions singly, and is necessarily less than the sum of the transactions, is
all that is paid in money. and perhaps even this is not paid, but carried over in an account current to the next year.
A single payment of a hundred pounds may in this manner suffice to liquidate a long series of transactions, some of
them to the value of thousands.

But secondly. The debts of A to B may be paid without the intervention of money, even though there be no reciprocal
debts of B to A. A may satisfy B by making over to him a debt due to himself from a third person, C. This is
conveniently done by means of a written instrument, called a bill of exchange, which is, in fact, a transferable order
by a creditor upon his debtor, and when accepted by the debtor, that is authenticated by his signature, becomes an
acknowledgment of debt.

§4. Bills of exchange were first introduced to save the expense and risk of transporting the precious metals from
place to place. “Let it be supposed,” says Mr Henry Thornton,2 “that
there are in London ten manufacturers who sell their article to ten shopkeepers in York, by whom it is retailed; and
that there are in York ten manufacturers of another commodity, who sell it to ten shopkeepers in London. There would be
no occasion for the ten shopkeepers in London to send yearly to York guineas for the payment of the York manufacturers,
and for the ten York shopkeepers to send yearly as many guineas to London. It would only be necessary for the York
manufacturers to receive from each of the shopkeepers at their own door the money in question, giving in return letters
which should acknowledge the receipt of it; and which should also direct the money, lying ready in the hands of their
debtors in London, to be paid to the London manufacturers, so as to cancel the debt in London in the same manner as
that at York. The expense and the risk of all transmission of money would thus he saved. Letters ordering the transfer
of the debt are termed, in the language of the present day, bills of exchange. They are bills by which the debt of one
person is exchanged for the debt of another; and the debt, perhaps, which is due in one place, for the debt due in
another.”

Bills of exchange having been found convenient as means of paying debts at distant places without the expense of
transporting the precious metals, their use was afterwards greatly extended from another motive. It is usual in every
trade to give a certain length of credit for goods bought: three months, six months, a year, even two years, according
to the convenience or custom of the particular trade. A dealer who has sold goods, for which he is to be paid in six
months, but who desires to receive payment sooner, draws a bill on his debtor payable in six months, and gets the bill
discounted by a banker or other money-lender, that is, transfers the bill to him, receiving the amount, minus interest
for the time it has still to run. It has become one of the chief functions of bills of exchange to serve as a means by
which a debt due from one person can thus be made available for obtaining credit from another. The convenience of the
expedient has led to the frequent creation of bills of exchange not grounded on any debt previously due to the drawer
of the bill by the person on whom it is drawn. These are called accommodation bills; and sometimes, with a tinge of
disapprobation, fictitious bills. Their nature is so clearly stated, and with such judicious remarks, by the author
whom I have just quoted, that I shall transcribe the entire passage.3

“A, being in want of 100l., requests B to accept a note or bill drawn at two months, which B, therefore, on the face
of it, is bound to pay; it is understood, however, that A will take care either to discharge the bill himself, or to
furnish B with the means of paying it. A obtains ready money for the bill on the joint credit of the two parties. A
fulfils his promise of paying it when due, and thus concludes the transaction. This service rendered by B to A is,
however, not unlikely to be requited, at a more or less distant period, by a similar acceptance of a bill on A, drawn
and discounted for B’s convenience.

“Let us now compare such a bill with a real bill. Let us consider in what points they differ, or seem to differ. and
in what they agree.

“They agree, inasmuch as each is a discountable article; each has also been created for the purpose of being
discounted; and each is, perhaps, discounted in fact. Each, therefore, serves equally to supply means of speculation to
the merchant. So far, moreover, as bills and notes constitute what is called the circulating medium, or paper currency
of the country, and prevent the use of guineas, the fictitious and the real bill are upon an equality. and if the price
of commodities be raised in proportion to the quantity of paper currency, the one contributes to that rise exactly in
the same manner as the other.

“Before we come to the points in which they differ, let us advert to one point in which they are commonly supposed
to be unlike; but in which they cannot be said always or necessarily to differ.

“Real notes (it is sometimes said) represent actual property. There are actual goods in existence, which are the
counterpart to every real note. Notes which are not drawn in consequence of a sale of goods, are a species of false
wealth, by which a nation is deceived. These supply only an imaginary capital; the others indicate one that is
real.

“In answer to this statement it may be observed, first, that the notes given in consequence of a real sale of goods
cannot be considered as on that account certainly representing any actual property. Suppose that A sells 100l. worth of
goods to B at six months’ credit, and takes a bill at six months for it; and that B, within a month after, sells the
same goods, at a like credit, to C, taking a like bill; and again, that C, after another month, sells them to D, taking
a like bill, and so on. There may then, at the end of six months, be six bills of 100l. each, existing at the same
time; and every one of these may possibly have been discounted. Of all these bills, then, only one represents any
actual property.

“In order to justify the supposition that a real bill (as it is called) represents actual property, there ought to
be some power in the bill-holder to prevent the property which the bill represents, from being turned to other purposes
than that of paying the bill in question. No such power exists; neither the man who holds the real bill, nor the man
who discounts it, has any property in the specific goods for which it was given: he as much trusts to the general
ability to pay of the giver of the bill, as the holder of any fictitious bill does. The fictitious bill may, in many
cases, be a bill given by a person having a large and known capital, a part of which the fictitious bill may be said in
that case to represent. The supposition that real bills represent property, and that fictitious bills do not, seems,
therefore, to be one by which more than justice is done to one of these species of bills, and something less than
justice to the other.

“We come next to some point in which they differ.

“First, the fictitious note, or note of accommodation, is liable to the objection that it professes to be what it is
not. This objection, however, lies only against those fictitious bills which are passed as real. In many cases it is
sufficiently obvious what they are. Secondly, the fictitious bill is, in general, less likely to be punctually paid
than the real one. There is a general presumption, that the dealer in fictitious bills is a man who is a more
adventurous speculator than he who carefully abstains from them. It follows, thirdly, that fictitious bills, besides
being less safe, are less subject to limitation as to their quantity. The extent of a man’s actual sales forms some
limit to the amount of his real notes; and as it is highly desirable in commerce that credit should be dealt out to all
persons in some sort of regular and due proportion, the measure of a man’s actual sales, certified by the appearance of
his bills drawn in virtue of those sales, is some rule in the case, though a very imperfect one in many respects.

“A fictitious bill, or bill of accommodation, is evidently in substance the same as any common promissory note; and
even better in this respect, that there is but one security to the promissory note, whereas in the case of the bill of
accommodation, there are two. So much jealousy subsists lest traders should push their means of raising money too far,
that paper, the same in its general nature with that which is given, being the only paper which can be given, by men
out of business, is deemed somewhat discreditable when coming from a merchant. And because such paper, when in the
merchant’s hand, necessarily imitates the paper, which passes on the occasion of a sale of goods, the epithet
fictitious has been cast upon it; an epithet which haS seemed to countenance the confused and mistaken notion, that
there is something altogether false and delusive in the nature of a certain part both of the paper and of the apparent
wealth of the country.”

A bill of exchange, when merely discounted, and kept in the portfolio of the discounter until it falls due, does not
perform the functions or supply the place of money, but is itself bought and sold for money. It is no more currency
than the public funds, or any other securities. But when a bill drawn upon one person is paid to another (or even to
the same person) in discharge of a debt or a pecuniary claim, it does something for which, if the bill did not exist,
money would be required: it performs the functions of currency. This is a use to which bills of exchange are often
applied. “They not only,” continues Mr. Thornton,4 “spare the use of
ready money; they also occupy its place in many cases. Let us imagine a farmer in the country to discharge a debt of
10l. to his neighbouring grocer, by giving him a bill for that sum, drawn on his corn-factor in London for grain sold
in the metropolis; and the grocer to transit the bill, he having previously indorsed it to a neighbouring sugar-baker,
in discharge of a like debt; and the sugar-baker to send it, when again indorsed, to a West India merchant in an
outport, and the West India merchant to deliver it to his country banker, who also indorses it, and sends it into
further circulation. The bill in this case will have effected five payments, exactly as if it were a 10l. note payable
to a bearer on demand. A multitude of bills pass between trader and trader in the country, in the manner which has been
described; and they evidently form, in the strictest sense, a part of the circulating medium of the kingdom.”

Many bills, both domestic and foreign, are at least presented for payment quite covered with indorsements, each of
which represents either a fresh discounting, or a pecuniary transaction in which the bill has performed the functions
of money. Within the present generation, the circulating medium of Lancashire for sums above five pounds, was almost
entirely composed of such bills.

§5. A third form in which credit is employed as a substitute for currency, is that of promissory notes. A bill drawn
upon any one and accepted by him, and a note of hand by him promising to pay the same sum, are, as far as he is
concerned, exactly equivalent, except that the former commonly bears interest and the latter generally does not’. and
that the former is commonly payable only after a certain lapse of time, and the latter payable at sight. But it is
chiefly in the latter form that it has become in commercial countries, an express occupation to issue such substitutes
for money. Dealers in money (as lenders by profession are improperly called) desire, like other dealers, to stretch
their operations beyond what can be carried on by their own means: they wish to lend, not their capital merely, but
their credit, and not only such portion of their credit as consists of funds actually deposited with them, but their
power of obtaining credit from the public generally, so far as they think they can safely employ it. This is done in a
very convenient manner by lending their own promissory notes payable to bearer on demand: the borrower being willing to
accept these as so much money, because the credit of the lender makes other people willingly receive them on the same
footing, in purchases or other payments. These notes, therefore, perform all the functions of currency, and render an
equivalent amount of money which was previously in circulation, unnecessary. As, however, being payable on demand, they
may be at any time returned on the issuer, and money demanded for them, he must, on pain of bankruptcy, keep by him as
much money as will enable him to meet any claims of that sort which can be expected to occur within the time necessary
for providing himself with more: and prudence also requires that he should not attempt to issue notes beyond the amount
which experience shows can remain in circulation without being presented for payment.

The convenience of this mode of (as it were) coining credit, having once been discovered, governments have availed
themselves of the same expedient, and have issued their own promissory notes in payment of their expenses; a resource
the more useful, because it is the only mode in which they are able to borrow money without paying interest, their
promises to pay on demand being, in the estimation of the holders, equivalent to money in hand. The practical
differences between such government notes and the issues of private bankers, and the further diversities of which this
class of substitutes for money are susceptible, will be considered presently.

§6. A fourth mode of making credit answer the purposes of money, by which, when carried far enough, money may be
very completely superseded, consists in making payments by cheques. The custom of keeping the spare cash reserved for
immediate use or against contingent demands, in the hands of a banker, and making all payments, except small ones, by
orders on bankers, is in this country spreading to a continually larger portion of the public. If the person making the
payment, and the person receiving it, keep their money with the same banker, the payment takes place without any
intervention of money, by the mere transfer of its amount in the banker’s books from the credit of the payer to that of
the receiver. If all persons in London kept their cash at the same banker’s and made all their payments by means of
cheques, no money would be required or used for any transactions beginning and terminating in London. This ideal limit
is almost attained in fact, so far as regards transactions between dealers. It is chiefly in the retail transactions
between dealers and consumers, and in the payment of wages, that money or bank notes now pass, and then only when the
amounts are small. In London, even shopkeepers of any amount of capital or extent of business have generally an account
with a banker; which, besides the safety and convenience of the practice, is to their advantage in another respect, by
giving them an understood claim to have their bills discounted in cases when they could not otherwise expect it. As for
the merchants and larger dealers, they habitually make all payments in the course of their business by cheques. They do
not, however, all deal with the same banker, and when A gives a cheque to B, B usually pays it not into the same but
into some other bank. But the convenience of business has given birth to an arrangement which makes all the banking
houses of the City of London, for certain purposes, virtually one establishment. A banker does not send the cheques
which are paid into his banking house, to the banks on which they are drawn, and demand money for them. There is a
building called the Clearing-house, to which every City banker sends, each afternoon, all the cheques on other bankers
which he has received during the day, and they are there exchanged for the cheques on him which have come into the
hands of other bankers, the balances only being paid in money; or even these not in money, but in cheques on the Bank
of England. By this contrivance, all the business transactions of the City of London during that day, amounting often
to millions of pounds, and a vast amount besides of country transactions, represented by bills which country bankers
have drawn upon their London correspondents, are liquidated by payments not exceeding on the average 200,000l. 5

By means of the various instruments of credit which have now been explained, the immense business of a country like
Great Britain is transacted with an amount of the precious metals surprisingly small; many times smaller, in proportion
to the pecuniary value of the commodities bought and sold, than is found necessary in France, or any other country in
which, the habit and the disposition to give credit not being so generally diffused, these “economizing expedients,” as
they have been called, are not practised to the same extent. What becomes of the money thus superseded in its
functions, and by what process it is made to disappear from circulation, are questions the discussion of which must be
for a short time postponed.

1 To make the proposition in the text strictly true, a
corrective, though a very slight one, requires to be made. The circulating medium existing in a country at a given
time, is partly employed in purchases for productive, and partly for unproductive consumption. According as a larger
proportion of it is employed in the one way or in the other, the real capital of the country is greater or less. If,
then, an addition were made to the circulating medium in the hands of unproductive consumers exclusively, a larger
portion of the existing stock of commodities would be bought for unproductive consumption, and a smaller for
productive, which state of things, while it lasted, would be equivalent to a diminution of capital; and on the
contrary, if the addition made be to the portion of the circulating medium which is in the hands of producers, and
destined for their business, a greater portion of the commodities in the country will for the present be employed as
capital, and a less portion unproductively. Now an effect of this latter character naturally attends some extensions of
credit, especially when taking place in the form of bank notes, or other instruments of exchange. The additional bank
notes are, in ordinary course, first issued to producers or dealers, to be employed as capital: and though the stock of
commodities in the country is no greater than before, yet as a greater share of that stock now comes by purchase into
the hands of producers and dealers, to that extent what would have been unproductively consumed is applied to
production, and there is a real increase of capital. The effect ceases, and a counter-process takes place, when the
additional credit is stopped, and the notes called in.

2 Enquiry into the Nature and Effects of the Paper Credit of
Great Britain, p. 24. This work, published in 1802, is even now the clearest exposition that I am acquainted with, in
the English language, of the modes in which credit is given and taken in a mercantile community.

5 According to Mr. Tooke (Inquiry into the Currency Principle, p.
27) the adjustments at the clearing-house “in the year 1839 amounted to 954,401,600l., making an average amount of
payments of upwards of 3,000,000l. of bills of exchange and cheques daily effected through the medium of little more
than 200,0001. of bank notes.” At present a very much greater amount of transactions is daily liquidated, without bank
notes at all, cheques on the Bank of England supplying their place.